Investment Analysis

Chapter 8Investment AnalysisCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedChapter OverviewInvestment AnalysisApplication of TVM and Market ValueWACCDiscount RateCapitalization Method of ValuationCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedChapter OverviewInvestment Analysis ToolsPayback periodNPVIRRMIRRFactors Impacting Investment AnalysisCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedComponents of Investment AnalysisWACCDiscount RateCapitalization Method of ValuationCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedWACCUsed to calculate present value of an investmentRate used to discount future cash flowsMix of debt and equity depends on how much the company can borrow and pay debt serviceCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedWACC ReviewAmount of interest expense and cash flow allotted to equity investors divided by the amount of capitalTakes into consideration:Capital mixTax effectInterest portion of debt service treated as an expense for tax purposes in the USCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedWACC CalculationWACC = wd kd (1-T) + we ke Weight of debt = wd Cost of debt = kd (1-T) Tax rate of business = T Tax effect = (1-T) Weighted cost of debt = wd kd (1-T) Weight of equity = we Cost of equity = ke Weighted cost of equity = we ke Copyright © 2007 by John Wiley & Sons, Inc. All rights reservedDiscount RateIncludes the cost of debt and investor’s required ROIUsed to calculate present value of an asset by discounting each year’s cash flowCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedCapitalization Method of ValuationValues the asset’s prior twelve months’ cash flowProvides the asset’s approximate market value Cap Rate Method Equation CR (X) = CF or X = CF/CR X = estimated current market value CR = cap rate (WAAC) CF = prior or trailing 12 months of cash flowCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedInvestment Analysis ToolsPayback PeriodAmount of time a project requires to pay back the initial equity investmentAdvantageEasy to calculateDisadvantagesDoes not include the time value of moneyIgnores cash flow after the required payback periodCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedPayback Period CalculationPayback Period = cost / incremental cash flowAn asset costs $25,000 and will provide incremental cash flows of $10,000 per year. = $25,000 / $10,000 = 2.5 yearsCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedInvestment Analysis ToolsNet Present Value (NPV)Calculates the difference between an asset’s present value and purchase priceAdvantagesTakes into account all cash flowsTakes into consideration the TVMDisadvantageDifficult to compare multiple investment opportunities with different costsCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedNPV Calculation |----------|----------|----------|----------|----------| 0 1 2 3 4 5 Years 50 100 300 305 320 at 10% interest -800Utilize [CF] button and enter:CF0 = -800CF1 = 50CF2 = 100CF3 = 300CF4 = 305CF5 = 320Now enter [CPT][NPV]I/Y = 10CPT NPV = -$39.49Do not invest!Copyright © 2007 by John Wiley & Sons, Inc. All rights reservedInvestment Analysis ToolsInternal Rate of Return (IRR)Discount rate that makes the NPV of an investment equal to zeroAdvantageCompare multiple deals with varying sales prices and costsDisadvantagesAssumes cash flows generated by the project are reinvested at the IRR calculatedMultiple IRRs when cash flows go from negative to positiveCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedIRR Calculation |----------|----------|----------|----------|----------| 0 1 2 3 4 5 Years 50 100 300 305 320 -800Utilize [CF] button and enter:CF0 = -800CF1 = 50CF2 = 100CF3 = 300CF4 = 305CF5 = 320CPT IRR = 8.5%Copyright © 2007 by John Wiley & Sons, Inc. All rights reservedInvestment Analysis ToolsModified Internal Rate of Return (MIRR)Rate of return which assumes all cash flows are reinvested at the firm’s WACCMIRR is more conservative than IRRCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedFactors ImpactingInvestment AnalysisCost of capital (WACC)Cap rate used to calculate the assumed sale price at the end of the analysis periodAmount and timing of annual cash flows projectedAcquisition price or development cost of the assetCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedFactors ImpactingInvestment AnalysisCost of CapitalThe more financial leverage used, the lower the cost of capitalThe lower the cost of capital, the lower the discount rateThe lower the discount rate, the higher the present value and NPVCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedFactors ImpactingInvestment AnalysisCap RateThe lower the cap rate, the higher the sales price and PV, NPV, and IRRThe higher the cap rate, the lower the PV, NPV, and IRRCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedFactors ImpactingInvestment AnalysisAmount and Timing of Projected Cash FlowsThe more cash flow projected in the early years, the higher the PV, NPV, and IRRCopyright © 2007 by John Wiley & Sons, Inc. All rights reservedFactors ImpactingInvestment AnalysisAcquisition PriceThe lower the price of the asset or total project cost, the higher the NPV and IRRCopyright © 2007 by John Wiley & Sons, Inc. All rights reserved